Shilling sees up to 78% annual return in next two years

Shilling sees a bull market in long-term bonds continuing into the near future, in spite of recent warnings about the bond market. It sounded too good to be true. So good, I couldn't resist asking him about his prediction in his recent Forbes column, "The great stock fallacy." Listen:

"If mild deflation unfolds and pushes Treasury bond yields to 3 percent, a contraction in long Treasuries yield from 5 percent to 3 percent over the next two years would give you a compound annual total returns of 23 percent," Shilling says. "That's lots more than you can expect from stocks." And in his February Insight Newsletter he added: "A 30-year zero coupon will gain 78 percent if yields go from 5 percent to 3 percent."

Asset allocation a straight jacket

Shilling doesn't hold out much promise for the stock market. He insists bonds are where the money will be made, not stocks. But you won't hear that from portfolio managers locked into specific allocations of stocks.

In Shilling's latest Insight, he says, "Investors are learning the hard way that asset allocation isn't an exact science." During the good old days of the 1990s bull market, portfolio managers gravitated into what Shilling calls the "pigeonhole investment strategy."

Unfortunately, "pigeonholing" locks a manager onto rigid asset allocation percentages, and then rigidly forces them to perform against their peer-group benchmark index -- even when the portfolio loses and continues losing money.

Pigeonhole investing is dangerous

When the market was rising steadily a few years ago, Shilling says portfolio consultants "massaged the data, isolated trends, assumed the good times would last forever, and then conveyed the resulting portfolio allocations to fund managers and other asset owners" like you and me.

This system "spawned a whole new approach to asset management," Shilling says. "Managers are now hired as specialists to fill specific pigeon holes and are given no latitude to stray" beyond their peer group and benchmark index.

To justify their performance, portfolio managers must "brush aside negative showings and crow that they have beaten their benchmarks, the S&P 500, the Philadelphia Semiconductors index, whatever."

But so what? Who gives a hoot whether they're beating an index? They're still losing your money, say Shilling, and "you shouldn't pay a manager, at least not for long, for beating his benchmarks if he's still losing your money!"

Shilling's very emphatic about this. Asset allocation may be a great theory, but in practice, "It's clear that this strategy doesn't work," he says. Just look at the 45 percent losses the last three years.

What works? Shilling points to the 14 percent annual returns of long-term bond market the past three years.

And what about the future? Shilling is looking at total returns for bonds of 23 percent annually and as much as 78 percent in the next two years if "mild deflation" occurs and you bet on long-term Treasuries.

Too good to be true?

Of course, that runs contrary to recent warnings we reported on. Both Pimco's bond guru Bill Gross and Vanguard have been telling investors that "the party's over" for bonds.

Shilling's forecast also conflicts with comments made by another Forbes columnist and fixed-income money manager, Marilyn Cohen. In her Jan. 20 column, "That's All Folks," Cohen wrote, "With the end of the bond party at hand, you need to shift your holdings from long-term bonds to medium-term ones."

Why? "Long-term rates are more likely to go up than down from here," Cohen says. We heard a similar warning back in April 2002 showing how bond fund performance goes down when the Fed rate goes up, and vice versa, covering the period from 1989 to 2002.

Zero-coupons in 'bond rally of a lifetime'

Shilling disagrees with these bears, Gross, Cohen and Vanguard: "I've been a Treasury bull since I started talking about the bond rally of a lifetime two decades ago." And he's not changing his tune now. The difference between him and them is simple: His economic radar sees deflation ahead. Deflation will drop the long bond yield from 5 percent to 3 percent.

What excites Shilling most? Zero-coupon, long-term Treasurys.

"Suppose you bought a 25-year zero-coupon Treasury bond in October 1981 when the yield was at it's peak ... If you rolled it over each year into another 25-year zero coupon to maintain the 25-year maturity, at the end of 2002, when long Treasurys yield 5.1 percent, you'd have a gain of 7,529 percent, or a 23.9 percent annual rate of gain without tax considerations. In contrast, if you'd bought the S&P 500 index at its trough in July 1982 and reinvested dividends, at the end of last year, you would have gained 1,367 percent, a 13.9 percent annual pre-tax rate."

Yes, you might question Shilling's deflationary forecast. But the fact that bonds beat stocks on an average annual basis 23.9 percent to 13.9 percent over the past two decades using that strategy is a convincing story.

What should you do? Shilling makes a persuasive argument against asset allocation and for increasing deficits and deflation, but dumping stocks altogether to put 100 percent of your money in zero coupon bonds would be too traumatic for most investors. If you're game, however, Shilling says it's real easy to do: "Just go into your bank or broker and buy the bonds direct!"

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